Investment Company Act of 1940

The Investment Company Act of 1940 establishes regulations for any company whose primary business involves "investing, reinvesting, or trading in securities." This broad definition includes all types of investment funds, including hedge funds that are offered privately to investors. Under this law, these companies must register with government regulators, which then subjects them to strict rules about how much money they can borrow and how they can operate.

Most investment funds organize themselves to avoid registering under this law because the required restrictions would severely limit their business operations. Before 1996, when Congress created Section 3(c)(7), private funds nearly always relied on the exemption found in Section 3(c)(1).

Section 3(c)(1) exemption: This exemption allows funds to avoid registration if they have no more than 100 "beneficial ownersInvestors who have economic ownership in a fund, counted for purposes of the Section 3(c)(1) exemption's 100-investor limit." (essentially, investors who have economic ownership in the fund) and do not offer their securities to the general public. This meant that early hedge fund managers could operate without registration by simply limiting their investment partnerships to 100 or fewer limited partners.

Section 3(c)(7) exemption: Congress added this alternative exemption through the National Securities Markets Improvement Act of 1996Federal legislation that created the qualified purchaser standard and Section 3(c)(7) exemption for private funds.. Unlike the 3(c)(1) exemption, Section 3(c)(7) allows funds to accept an unlimited number of investors. However, there's a catch: all investors must qualify as " qualified purchasers Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. "—individuals or institutions that meet higher wealth requirements than typical accredited investors Accredited investor An accredited investor refers to an individual or entity that meets specific financial thresholds set by securities regulations, qualifying them to invest in unregistered securities offerings such as hedge funds, with standards including minimum income or net worth requirements. . The fund also cannot make public offerings of its securities.

Registration under the Investment Company Act would create several significant restrictions that would fundamentally change how hedge funds operate. These limitations would make many traditional hedge fund strategies impossible or unprofitable.

Leverage limitations: Section 18Provision of the Investment Company Act that restricts registered funds' borrowing by requiring specific asset coverage ratios. of the Act restricts how much money registered funds can borrow by requiring specific "asset coverageFinancial ratios required under the Investment Company Act that measure the value of fund assets relative to outstanding debt obligations." ratios. In practical terms, this means the fund's assets must be worth a certain multiple of any debt it takes on. The law generally prohibits registered companies from issuing "senior securitiesFinancial instruments like preferred stock or bonds that have priority over common shares when paying dividends or liquidating assets."—financial instruments like preferred stock or bonds that have priority over common shares when the company pays dividends or liquidates. This would severely limit hedge funds' ability to use borrowed money to amplify their investment returns.

Investment restrictions: Registered funds face limits on several types of investments that hedge funds commonly use. They cannot invest heavily in other registered investment funds, securities of companies in the financial services industry, or securities of insurance companies. These restrictions would prevent many diversification strategies and limit access to certain market sectors.

Corporate governance requirements: Registration imposes strict requirements for board composition and other governance structures. These rules would require hedge funds to operate more like traditional mutual funds, with independent directors and formal oversight processes that could slow decision-making and increase costs.

Performance-based compensation constraints: Until regulatory changes in 1985, registration would have completely prevented funds from paying managers based on a percentage of the profits they generated for investors. Even after 1985, registered funds face more restrictions on performance-based fees than private funds do.

When hedge funds first emerged, managers had to navigate several different regulatory frameworks that still apply today. Beyond the Investment Company Act, hedge fund managers needed to determine whether offering fund securities would require registration under the Securities Act of 1933, whether they themselves would need to register as investment advisers under the Investment Advisers Act of 1940 Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. , and whether the fund would need to register as a broker-dealerA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. under the Securities Exchange Act of 1934.

This complex regulatory landscape shaped how hedge funds structured themselves from the beginning. The exemptions under the Investment Company Act became crucial tools for maintaining operational flexibility while staying compliant with securities laws.

In recent years, financial advisers and intermediaries have increasingly demanded alternative investment products they can offer to their clients. This shift reflects changes in how investment professionals think about portfolio constructionThe process of selecting and combining different investments to achieve specific risk and return objectives.—most now recommend that clients allocate some portion of their investments to alternative asset classesInvestment categories beyond traditional stocks and bonds, including hedge funds, private equity, real estate, and commodities. and strategies that go beyond traditional stocks and bonds.

Traditional hedge fund structures don't serve this broader market well. The investor limits required by Section 3(c)(1), the high wealth requirements for qualified purchasers under Section 3(c)(7), and the typically high minimum investment amountsThe smallest dollar amount that a fund will accept from new investors, typically set to limit administrative costs. make these funds inaccessible to many investors who work with financial advisers.

As a result, some hedge fund strategies have been adapted for registered fund structures that can serve this wider market. Most hedge fund investment approaches—except for certain highly leveraged strategies that require significant borrowing—can operate while complying with Investment Company Act requirements. Interestingly, even highly leveraged strategies may be possible in registered funds if managers implement them through derivativesFinancial instruments whose value is derived from underlying assets, including options, futures, swaps, and forwards. rather than traditional borrowing, though this requires careful navigation of the leverage restrictions.